In this article, I will walk through the structure and terms of the CARE instrument. For those founders who find financial articles similar to the effect of melatonin, please bear with me. You must understand alternative ways to raise risk capital and become educated on those options. The CARE is not a panacea but a good choice for those building great brands and businesses grounded in good fundamentals.
The CARE offers investors a structured exit. It is self-liquidating. That means a subsequent equity round or acquisition is unnecessary for the investor to see a return.
Let’s dig into the mechanics. I will do so using a fictional example. Meet Elliot’s Wellness Shots. Elliot’s is projected to finish this year at a little over $2.5MM in revenue, with planned growth increasing revenue to $18MM annually by year five. They have good unit economics resulting in solid margins. While Elliot’s planned growth is significant, it does not have the exponential growth potential that aligns well with the typical venture fund. Elliot’s is putting profit before growth, and with the current state of the M&A activity, it is not sure about the potential of an exit. They need to raise about $500k to support their growth and have decided to raise it using a CARE.
A CARE is not equity; some may argue it would be considered debt. It is an instrument intended to provide risk capital and has the expected return associated with that form of funding. It is not senior indebtedness, so it is subordinate to asset-based lending and other secured forms of debt.
A CARE has only a few negotiated terms that require agreement between the founder and the funder. The first is the amount of the investment. In this case, Elliot’s Wellness plans to raise the $500k. The second is the expressed return offered to the investor, called the “COGS Payment Cap.” In this case, Elliot’s is offering a 2X return. The third negotiated point is the percentage of COGS that will determine the quarterly payment. Elliot’s is offering payments of 4% of COGS.
In addition to the above, a minimum quarterly payment must be established. Elliot’s Wellness offers a guaranteed quarterly payment of 1% of the investment amount. Another point is a discount on the COGS Payment Cap. If the money is returned by the 24th month, there is a 25% reduction to the COGS Payment Cap. The final is a warrant provision. We will return to that shortly.
If both parties agree to the above terms, Elliot’s Wellness will pay the investor the equivalent of 4% of their COGS each quarter. Please see the table below for an example.
Table 1
| Investment | % or COGS | Payment CAP | ||
| $500,000 | 4.00% | $1,000,000 | ||
| Quarter | Revenue | COGS | Payment | Payment CAP |
| Q1 | $550,000 | $302,500 | $12,100 | $987,900 |
| Q2 | $605,000 | $332,750 | $13,310 | $974,590 |
| Q3 | $665,500 | $366,025 | $14,641 | $959,949 |
| Q4 | $732,050 | $402,628 | $16,105 | $943,844 |
| Q5 | $878,460 | $483,153 | $19,326 | $924,518 |
| Q6 | $1,054,152 | $579,784 | $23,191 | $901,326 |
| Q7 | $1,264,982 | $695,740 | $27,830 | $873,497 |
| Q8 | $1,517,979 | $834,888 | $33,396 | $840,101 |
| Q9 | $1,745,676 | $960,122 | $38,405 | $801,696 |
| Q10 | $2,007,527 | $1,104,140 | $44,166 | $757,531 |
| Q11 | $2,208,280 | $1,214,554 | $48,582 | $708,949 |
| Q12 | $2,429,108 | $1,336,009 | $53,440 | $655,508 |
| Q13 | $2,672,019 | $1,469,610 | $58,784 | $596,724 |
| Q14 | $2,939,220 | $1,616,571 | $64,663 | $532,061 |
| Q15 | $3,233,142 | $1,778,228 | $71,129 | $460,932 |
| Q16 | $3,556,457 | $1,956,051 | $78,242 | $382,690 |
| Q17 | $3,912,102 | $2,151,656 | $86,066 | $296,624 |
| Q18 | $4,303,313 | $2,366,822 | $94,673 | $201,951 |
| Q19 | $4,733,644 | $2,603,504 | $104,140 | $97,811 |
| Q20 | $5,207,008 | $2,863,855 | $97,811 | $0 |
In this example, the investor would 2X their investment in five years. They will also remove all the risk by the 14th quarter, as the investment principal is fully returned. This derisking is a massive benefit of the CARE to the investor. The typical equity investment is a zero-sum game. Either they see a return from an exit or lose the investment principal. With a CARE, each quarter risk is off the table as payments are received, and there is almost no chance of a zero return.
What about upside participation? If Elliot’s Wellness grows and suddenly recognizes the potential for an exit, how would the investor in a CARE participate? As mentioned above, there is a warrant provision. Before executing the CARE, the founder and funder will negotiate the issuance of a warrant based on a percentage of the invested amount. In the case of Elliot’s Wellness, the terms are for a warrant equal to 100% of the invested amount of $500k. Elliot’s will issue the Investor a warrant to purchase common stock of the company at an exercise price equal to the most recent 409A or agreed upon fair market value of the company (the “FMV”) and for a number of shares equal to 100% of the invested amount divided by the FMV. The investor can exercise the warrant if the CARE remains in place. The investor can exercise the warrant and participate in the upside if a potential acquisition exists.
The CARE is best suited to brands that are also building good businesses. It necessitates good margins, a path to profitability, and capital efficiency. There is much to explore and discuss here, and it is difficult to put it all in a short article. We are making the CARE available as an open-source document. You can download the template from our website. We will also be hosting some virtual Q&A’s to help further educate both founders and funders about the instrument. Please reach out with any questions.
A tip of the hat to Chuck Cotter and the team at Holland and Hart for their help and brainpower in developing this offering.
